Data Buffet: Buyout Firms Graduate From Debt-Fuelled Returns

Operational improvements, rather than debt, have fuelled returns at private equity-backed businesses sold since the financial crisis, according to a new study which challenges the view that leverage has driven returns from boom-era deals.

Of the companies that were bought by buyout firms between 2005 and 2008 – and have since been sold – operational improvement was a key factor in boosting returns, according to a new study by Switzerland-based private equity investor Capital Dynamics and Technische Universität München.

After excluding leverage, private equity deals averaged an annual unlevered return of 28% compared to 14% for public equities, resulting in operational private equity alpha of 14%. This compares to 6% recorded in a study by the same researchers in 2009, which did not factor in deals between 2005 and 2008.

The findings challenge the view by some industry figures that leverage has fuelled returns from deals made during the buyout boom. For private equity deals made between 2005 and 2008, 40% of value was created through growth in EBITDA and 29% through leverage.

This represents a shift from deals made between 2001 and 2004, when 31% of value was created through EBITDA growth and 35% through leverage.

“Despite the higher entry leverage across deals made during the buyout boom, the leverage contribution in value creation was lower,” said Kairat Perembetov, a vice president in research at Capital Dynamics. “EBITDA growth was the highest single value creation driver across those deals, and that explains why the leverage contribution was lower, because with the deals that were made during the buyout boom general partners had to work on the growth of EBITDA in order to pay down the higher entry leverage that was put into those deals.

“You read all these things about private equity just being financial engineering, this study shows that this is not the case,” he said.

Oliver Gottschalg, a professor at HEC Paris and founder of Peracs Analytics, who was not connected with the study, said that the message from the findings is particularly relevant to investors.

“Some of them might have wondered ‘what does private equity really do for the fees we’re paying other than generating leveraged equity returns?’” he said.

“Now we’re realizing that there has been alpha even after the crisis, and these guys actually do something beyond leverage that fundamentally enhances the profitability of the target that they acquire. That is an important message for limited partners [investors] to consider with respect to where they want to put private equity in their asset allocation going forward.”